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Telefonica (NYSE:TEF) is a telecommunication company that has seen its share price slide over 50% in the past 2 years. Telefonica is in a highly competitive industry, and one of its major operating segments - Europe - is on the brink of collapse. As a result, investors are slowly souring on the company, but here's why you shouldn't.

As a value investor, I like to find companies selling at a reasonable price that would justify a purchase. More often than not, Wall Street has fallen out of love with these "value" investments. However, the negative connotation Wall Street associates with these companies is not justified and creates a potential buying opportunity for keen investors.

In the following paragraphs, I will attempt to explain the positives and the negatives of the company.

The Good

Telefonica Digital

Telefonica Digital is Telefonica's new venture into the immense technological landscape. It is expected to do reasonably well; generating $5 billion in annual revenue by 2015, with substantial growth thereafter. This would provide an impressive 8% increase to Telefonica's annual revenue.

Below are business segments within Telefonica Digital, taken from Telefonica's Website here.

  1. Financial Services (digital wallets, digital remittances, and micro credits and insurance)
  2. M2M (transport, utilities, small and large enterprise services)
  3. Advertising (Mobile advertising, location-based services, loyalty schemes/offers)
  4. eHealth (Remote patient monitoring, teleconsultation, tele-care, demand and access management)
  5. Video and Media (IPTV, OTT video, CDN's, Terra)
  6. Security (managed security services, clean pipes, mobile and PC security)
  7. Cloud (Virtual data centers)
  8. Applications (BlueVia, WAC)

M2M is the most promising of the 8 services because it integrates Telefonica's existing Telecom portfolio into its enterprise services. With the integration of the two, businesses are able to have a greater insight on consumers which in turn will generate improved operating efficiency.

For example, with Telefonica's 310 million subscribers in 24 different countries, businesses are able to gather valuable insight on consumers and their behaviors; valuable insight that could generate greater business profitability and efficiency. Thus, offering potential enterprise customers a compelling reason to use M2M over other similar services.

What I described above can be seen here.

Diverse Telecom Operations

Telefonica has major operations in both Latin America and Europe. With Latin America accounting for roughly 51% of Telefonica's sales, while Europe accounted for the remaining 49% of revenues. With the majority of revenue coming from Latin America, Telefonica is less susceptible to problems in Europe than other similar carriers. Therefore, Telefonica is better positioned to play a rebound in the European economy.

European sales declined year-on-year due to the recession in Europe; however, Latin America Sales actually grew by an impressive 6.8%. The decline in European sales were offset by the growth in Latin America; as a result, revenues were flat year-on-year. However, Europe will recover, and when it does you can expect Telefonica Europe to resume growth at a modest rate. European sales would no longer be a drag on revenues, and would undoubtedly grow along with Latin America. This would result in an overall growth in sales year-on-year, and with the stock being priced at revenue declines, any material growth would make the company worth significantly more intrinsically.

Telefonica's Balance Sheet

The following table compares Telefonica's balance sheet to its peers.

CompanyD/E RatioROE %ROA %P/BGross Profit Margin %P/E
Telefonica3.00619.16%3.13%2.11270.76%10.88
Vodafone (NASDAQ:VOD)0.5792N/AN/A1.29630.53%228.52
Orange1.332N/AN/A0.576754.46%24.53

Telefonica has an unimpressive debt to equity ratio of 3.006; debt is a problem for Telefonica and should be considered upon before investing. Nonetheless, Telefonica is the most profitable company of the group, and has the highest return on equity of any major telecom - including ones not listed in the preceding table. However, the abnormal ROE can be explained by Telefonica's abnormal debt position. Leverage multiples earnings on equity and can give the mirage of a more profitable company. If leverage were to be discounted to the industry average, Telefonica's ROE would be in line with the industry.

Notably though, Telefonica is still generating profits, even in Europe's tough macro environment while similar telecoms are losing money. This has nothing to do with Telefonica's leverage; rather, it is a testament to Telefonica's strong staying power in any environment. For this reason, Telefonica would be better suited to withstand the ongoing recession in Europe than any other telecom company.

Although Orange and Vodafone trade lower relative to book value compared to Telefonica, they still are relatively unprofitable companies. Thus, price to book is not an accurate representation of such companies. Allow me to elaborate further: Orange, the least profitable company of the group trades at a discount to book value. However, the losses from continuing operations will erode the book value and would eventually represent a premium to book value. Telefonica, the most profitable company of the group, trades at a premium to equity. Large profits made will accelerate equity growth; as a result, Telefonica's price/book ratio will eventually level to a more appealing number to value investors.

The Current Ratio

Telefonica has a current ratio 0.7278 - implying that Telefonica can not pay its short term liabilities. However, the current ratio must be used in context to the type of industry the company is in. In Telefonica's case, it turns over its inventory every 6 days. As a result new products can be paid off and returned to manufacturers fairly quickly. Thus, allowing Telefonica to have a higher accounts payable number than an illiquid company. Furthermore, a telecommunication company with a high current ratio would imply that the company is conservative with its business and is not taking advantage of its liquidity.

The Bad

The Debt Situation

Telefonica has over $64 billion in debt which makes up about half of its assets (anything around 50% is considered strong); however, Telefonica also has a debt to equity ratio of 3 (any ratio below 2 is considered strong) which is above the industry average, and far above fellow competitors. Telefonica is highly leveraged compared to peers and investors who like a strong balance sheet may not like Telefonica.

CompanyDebt/Equity Ratio
Telefonica3.006
America Movil (NYSE:AMX)1.629
Orange (NYSE:ORAN)1.332
Vodafone0.5792

Telefonica is in the midst of lowering its debt burden to a more acceptable level; as a result, management suspended the dividend last year, but is expected to continue a dividend this year at a lower yield of 6%. However, if problems persist in Europe, this still generous dividend may be suspended again. Therefore, I don't see the 6% dividend being sustainable in this present macro environment, and if you're buying Telefonica simply for the yield, I would reconsider.

Competitive Environment

Telecommunications is a highly competitive market. Consumers readily switch to the carrier that offers the best rates. This is especially true in tough macro environments such as the one we are seeing in Europe. Competing carriers can lure new customers with more value oriented plans, thus, causing erosion in the business of the less value oriented carrier - something that could cause disaster. The latter carrier would have to reduce pricing, or be forced out of business. This causes a vicious cycle of margin compression and lower profitability, which makes running a telecom company highly unprofitable in tough economic periods.

Such a case is best shown by two telecom companies in France: Orange and Iliad. Where Orange lost significant market share from the lower cost competitor (Iliad), customers readily switched from Orange to Iliad based on pricing alone. Iliad was successfully able to steal customers right from under Orange's nose, and Orange's business started to erode away while Iliad's was growing at a rapid pace - even in the midst of France's recession.

However, Telefonica operates in many segments and is not as heavily dependent on one country like Orange is. In addition, Telefonica has been performing well even with increased competition, thus, showing Telefonica's ability to attract customers with both quality and value. For this reason, I believe the likelihood of a new competitor significantly affecting Telefonica's business is unlikely.

Conclusion

Telefonica is a great company in a terrible macro environment, but that doesn't mean the terrible conditions will persist indefinitely. Therefore, Telefonica could be an excellent play on a rebound in the European economy, but if problems in Europe are to persist, Telefonica may have significant problems with its debt. Brave investors who have a stomach for volatility may consider adding Telefonica to their portfolios.

Disclosure: I am long TEF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Telefonica: The Good And The Bad